Question

The Upland company has 30 million shares of common stock outstanding, and the current market price per share of the common stock is $20.00. Long-term debt outstanding is $400 million. The market yield of the debt is 6% and the common stock has an equity beta of 1.50; the risk-free rate of return is 3% and the expected return on the market portfolio is 12%. Also, Upland pays tax at the rate of 25%. Upland is considering a project in the company's existing line of business. What is the required rate of return for this project?

Answer 1

MV of equity=Price of equity*number of shares outstanding

MV of equity=20*30000000

=600000000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*400000*1

=400000000

MV of firm = MV of Equity + MV of Bond

=600000000+400000000

=1000000000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 600000000/1000000000

W(E)=0.6

Weight of debt = MV of Bond/MV of firm

Weight of debt = 400000000/1000000000

W(D)=0.4

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 3 + 1.5 * (12 - 3)

Cost of equity% = 16.5

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 6*(1-0.25)

= 4.5

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.5*0.4+16.5*0.6

WACC =11.7%